The Macro View by Lionomics, February 2022

MoneyLion works with Wilshire, one of the nation’s largest investment research consultants, to bring you investment advice and market insights. Each quarter in The Macro View, we bring you Wilshire’s quarterly viewpoints on the big economic stories, with insights about the asset classes that may appear in your investment portfolio. Let’s dive into the latest quarter.

The Macro View Wilshire Investment strategy update — February 2022

The recent decline in equity and fixed income markets and the associated spike in both equity and interest rate volatility is reflective of a market that is increasingly focused on monetary policy. Inflation has become the focal point for most investors, consumers, and central bankers/policy makers. Inflation was dismissed by many (including the Federal Reserve) as being transitory only six months ago and is now viewed as potentially sticky and potentially one of the biggest risks to the global economy. Fortunately, most major economies are forecast to deliver strong levels of real GDP growth in 2022, albeit at lower rates than in 2021.

Furthermore, strong household balance sheets and higher wages in the US are supportive of personal consumption (spending) in the face of higher inflation, and while the global economy is grappling with very elevated levels of inflationary pressures, it’s important to recognize that short-term cyclical factors have meaningfully contributed to these pressures. At the same time, we have seen a material rise in rent expenses in the second half of 2021 coupled with elevated levels of wage inflation. The Fed’s more hawkish tone regarding monetary policy is warranted, while remaining data dependent and nimble in policy implementation.

In this quarter’s update:

We discuss the potential impact of tighter financial conditions on equities and fixed income, as investors balance the impact of higher interest rates against earnings growth ( trade off between risk and return ) and a relatively strong global economy. As real rates continue to rise, more attractively valued segments of global markets should remain in favor, while more highly valued assets may remain under pressure. This helps inform Wilshire’s decision to maintain an underweight view for  US growth and favor non-US equities relative to US equities. 

Wilshire remains underweight duration risk and core fixed income in favor of more flexible/alternative mandates that exhibit less duration exposure because the change in monetary policy continues to fuel heightened interest rate risk. Wilshire also recognizes that sentiment is prone to overreaction, and investors may consider that markets might be overpricing the risk of inflation in the short-term. 

Wilshire continues to view inflation as a risk in the near-term and remains modestly overweight to commodities and other reflationary exposures such as US value equities, but are actively managing any exposure to these views and seeking to partially monetize positions as volatility works in their favor. Wilshire continues to promote diversification and remains judicious in the allocation of our active risk budget, particularly as they witness market conditions reaching inflection points. They provide a summary of their positioning, rationale, and supporting exhibits in the following sections.

Asset class perspectives February 2021

• Fixed income vs. equity. Despite a positive economic outlook, which would normally be expected to benefit equities coming out of a recession, valuations are not materially more attractive in equities vs. fixed income, resulting in a neutral posture.

• Large cap vs. small cap equities. Wilshire does not see a meaningful valuation opportunity between large caps and small caps.

• Growth vs. value equities. US value equities offer more attractive valuations and both fundamentals and sentiment now favor value, as growth equities face headwinds from tightening financial conditions. Therefore, Wilshire maintains  their overweight view in value equities, however Wilshire continues to actively manage our exposure to this view. 

• Global ex-US vs. US equities. Wilshire expects tighter financial conditions to weigh on US equities more than non-US equities, and find relatively attractive valuations in non-US equities. Improving COVID-19 conditions and more pro-cyclical exposure in foreign markets are also supportive of this view. Therefore, Wilshire maintains overweight to non-US equities.

• Emerging markets vs. developed equities and US. While emerging markets offer attractive valuations, the technical, fundamental, and geopolitical backdrop heighten the downside risk of an overweight exposure to emerging markets relative to developed markets.

Macroeconomic look: Supply chain disruptions weigh on global growth

Economic activity is expected to slow across most major economies in 2022 (Exhibit A), while still delivering strong levels of GDP growth. 

Exhibit A: Lower, albeit healthy GDP growth expectations 

The combination of supply chain disruptions, labor shortages, and persistently high COVID-19 case rates resulted in persistent downgrades to economic activity since mid-2021 (Exhibit B).

Exhibit B: GDP forecasts trended lower on supply chain, labor shortage, and COVID concerns

Unfortunately, the same factors are also beginning to weigh on sentiment, most notably in the services sector. Services PMIs have been softening across most major developed markets, while still signaling expansion (Exhibit C). (Note: PMI stands for Manufacturing Purchasing Managers’ Index, which measures the activity level of purchasing managers in the manufacturing sector.)

Exhibit C: Services PMIs reflect weaker sentiment

Fortunately, fourth quarter US GDP growth outpaced expectations due to strong personal consumption of services and private domestic investment, specifically inventories, which added 4.9% to GDP growth (Exhibit D). 

Exhibit D: 4Q US GDP outperforms on inventory rebuilding and consumption of services

Businesses have been faced with supply shortages and inventories have been insufficient to keep up with the demand for goods. Exhibit E shows a significant decline in the ratio of retail inventories/sales that coincided with a high percentage of purchasing managers reporting slower deliveries. There are some signs the supply chain conditions are improving, as more recent surveys show a decline in the percent of purchasing managers reporting slower deliveries, which will be supportive of the inventory rebuilding cycle and may continue to serve as a tailwind to GDP growth as companies restock.

Exhibit E: Retail inventories have declined materially

Sentiment, technicals, and risk

The recent spike in both equity market volatility and interest rate volatility is reflective of deteriorating market sentiment (how investors feel about the market), which has been gradually weakening since mid-2021 (Exhibit F) potentially due to persistently elevated levels of COVID-19 cases and inflation, in addition to the prospect of tighter monetary policy. 

Exhibit F

While fixed income market valuations continue to exhibit complacency, particularly in nominal bonds, Fed funds futures appear to be pricing a very hawkish policy stance (less accommodative practices by the Fed) in 2022, as discussed in our fixed income outlook. Last quarter, Wilshire expressed its view that US equities, most notably large cap growth companies, had benefited from extraordinarily accommodative financial conditions and that a shift in financial conditions would likely serve as a headwind for higher-valued segments of the market. That expectation has come to fruition rather quickly, with technicals and Fed policy taking center stage in early-2022.